• The nerd-speak of options trading means
every moving part of your trading life has a
handy phrase to describe it. Naturally, you
trade with the intent to make a profit. So
“return on capital” (ROC) is the technical
phrase that describes the yacht you one day
hope to buy from all your hard work. But
let’s take a deeper look at this term.

LIT TLE-KNOWN FACTS

Naturally, you enter a trade with the idea
of making a return. It may not always work
out that way. But you consider your capital
investment and the trade’s maximum (max)
profit potential. These two pieces of data
comprise ROC. To wit: ROC = max profit ÷
capital used (buying power reduction).

ROC gives you the percentage return ifyour position makes max profit at expira-tion. If your position loses money, or theprofit is less than max—such as if you closeout the position before expiration—you’renot necessarily going to make that percent-age return. That’s why ROC doesn’t mea-sure your profit. Instead, it’s a tool that letsyou compare two strategies to gauge howe;ciently your capital is being used.

WHICH S TRATEGY IS BEST?

Say you compare two out-of-the-money
(OTM) puts on the same stock with adjacent strike prices. The ROC of these puts
lets you compare the potential return for a
given probability. So even though the probability of profit (POP) may be higher for the
further OTM put, the ROC might be lower.

Likewise, an undefined-risk strategy(versus a defined-risk strategy) will like-ly have a higher POP. But keep in mind:that undefined-risk strategy could have alower ROC. Usually, the POP and ROC arerelated inversely.To see ROC on the thinkorswim® plat-form from TD Ameritrade, from the Tradepage, bring up the options chain. Click onthe columns and select Layout. From thedropdown menu, choose Customize, andadd “Return on Capital”for one of the columns. TheROC value on your plat-form takes the midprice ofthe option or vertical anddivides it by the capitalrequired to take the posi-tion. (To learn more aboutcapital requirements for positions, read theMargin Handbook at https://www.tdamer-itrade.com/retail-en_us/resources/pdf/AMTD086.pdf.)

If you compare the ROC of single options and verticals, you may find the ROC
on the verticals is higher. That doesn’t
necessarily mean the spread is a better
trade than the single option. It just means
that given the amount of capital investment, that’s the ROC you could potentially
make if you’re right.

IN A SMALL ACCOUNT where you may
want diversification across several positions,
ROC can illustrate how defined-risk strategies aren’t something to shy away from. Use
this tool to compare similar strategies like
a naked option to a vertical, or a straddle
to an iron condor. Which one gives you the
best possible bang for your buck? —Words by
JAYANTHI GOPALAKRISHNAN

Jayanthi Gopalakrishnan is not a representative
of TD Ameritrade, Inc. The material, views, and
opinions expressed in this article are solely those
of the author and may not be reflective of those
held by TD Ameritrade, Inc.

For more on the risks of trading and trading
options, see page 37, #1-2.

COOL TOOLS
Is it better to trade
single options or
spreads? The ROC
column on the
option chain could
tell you which is a
better bet.